BFP Management Blog

I’ve recently visited 4 of the 5 worst hit states in the country (my home California, Nevada, Florida and Georgia) for real estate and have noticed that apartment cap rates are now within 100 basis points of the peak of the market. When did yesterday’s weeds turn into today’s flowers?

I certainly understand that rents have declined from the peak so operations are lower than they were during the boom. This factors into the numbers through a lowered Net Operating Income (NOI). That said, the nation’s economy isn’t roaring back so NOI growth has yet to occur.

Single family houses and multi-family housing (apartments) have remained decently tethered over the last 30 years. When value in one sector goes does up or down, so does the other. Of late however, we are witnessing a temporary phenomenon, housing continues to fall while pricing of apartments is going up.

Figure 1

In Figure 1, we see that house prices have remained negative while the National Council of Real Estate Investment Fiduciaries (NCREIF) total return index has swung positive. It begs the question why has commercial real estate enjoyed a spike in returns while housing values have not recovered? It should be noted that cash on cash returns for investor owned houses has gone up much like the red line in Figure 1.

One positive for the commercial properties is that there wasn’t a huge construction boom in comparison to single family homes. There is also financing available for apartments (through Fannie Mae and Freddie Mac) while financing for investor purchased houses is very difficult (see April’s WASH Apartment Reporter – record number of cash purchases for single family homes).

More importantly, institutional investors (pension funds, REITS, hedge funds) are seeking yield and with the Fed pushing rates down, purchasing commercial real estate will generate more cash flow than bonds and money market funds. These investors need to place a lot of money and purchasing single family homes is much too time consuming and difficult.

A few years ago I was the lead investor in a joint venture with a large hedgefund which was announced in a press release delcaring that the new fund would buy large tranches of bad debt tied to single family homes. The strategy was to purchase residential mortgage back securities (RMBS) at a discount and then work out the loans with the borrower or foreclose and then either sell or hold and rent the houses. Almost immediately we were stunned to find out that there would be few to none of these large transactions because if there were a bulk sale, the underlying investors in these securitized instruments might not do as well as they would if each house were sold one by one. In any case, for fear of investor lawsuits, the dispositions happened on a per door basis and not in bulk. Sadly the best laid plans of mice, men and my fund went awry and never launched.

While there is and will continue to be opportunites for those willing to purchase houses in the inefficient manner dictated by the unraveling of the RMBS market, I remain concerned at how quickly apartment values have returned. In underwriting recent apartment foreclosures that were now for sale in both Atlanta and Las Vegas, I noted that to pull the trigger and purchase, one would need to assign very little for a risk premium and simply take the plunge and believe that there will be NOI growth. This was the very reason I stopped buying apartments in the US after 2002. I certainly may be missing the boat this round but as the philosopher Santayana said, “Those who cannot remember the past are condemned to repeat it.” Amnesia please!